III. ECONOMIC ENVIRONMENT Major trends and outlook The Korean economy is picking up steam, and, as of June 1994, no major risks for economic stability are on the horizon. Growth has been accelerating since mid-1993, and real GNP in the first quarter of 1994 rose 8.8 percent over year-earlier levels - the highest jump since the second quarter of 1991. Industrial production during January-April 1994 grew at a 9.6 percent annual rate, and the capacity utilization rate in factories exceeded 80 percent. The expansion is investment-led, as the large conglomerates implement ambitious plans to modernize and expand facilities. Exports, aided by the strength of the yen, remain brisk in 1994, although imports are rising at even a faster rate. Consumption spending, which accounts for over half of total GNP, is growing along with optimism about the economy. The U.S. Embassy predicts that real GNP growth, which averaged 5.6 percent in 1993, will exceed 7 percent in both 1994 and 1995. Despite faster growth, the economy displays no signs of overheating. Consumer prices jumped 3.3 percent between December 1993 and March 1994 due to food product shortages and public service tariff hikes, but remained basically stable in April and May. ROKG officials contend that Seoul will achieve its goal of 6 percent inflation between Decembers 1993 and 1994, particularly because the Bank of Korea intends to hold money supply growth toward the bottom of its 14 to 17 percent target range in the latter half of 1994. The Embassy expects that consumer price inflation, after a 4.8 percent performance in 1993, will be somewhat over 6 percent during the next two years. Producer price inflation, on the other hand, should stay in the 2 percent range. Principal growth sectors Within the context of a brightening macroeconomy, growth prospects vary widely across sectors. Agriculture and mining are in secular decline, dependent on government subsidies and trade protection for survival. The energy sector, on the other hand, is booming, due to government plans to expand electric power production - both thermal and nuclear - and to diversify into imported LNG. The manufacturing sector presents a mixed bag - heavy industries, such as chemicals, steel, autos, and electronics, are boosting capacity to meet strong domestic and export demand. However, light industries, including textiles and footwear, have lost competitiveness due to past wage hikes. Value-added by light manufacturing declined by 3.3 percent in 1993, while that by heavy manufacturers rose 8.6 percent. Even if output by the smaller producers recovers somewhat in 1994, growth in the manufacturing sector will probably remain skewed toward capital-intensive enterprises. The construction sector has traditionally been sensitive to ROKG stabilization policies, but demand for construction services will jump over the medium term due to a government program to encourage infrastructure development. The Korean service sector is growing more rapidly than the economy as a whole, and this differential may widen further if the ROKG follows through on its promises to deregulate the distribution, telecommunications, and banking and insurance sectors. Overregulation and oligopolistic practices have kept productivity and technical innovation in most service categories low, so liberalization could spark substantial catch-up growth. Value-added in the telecommunications sector will be enhanced by the introduction of new carriers and heavy hardware and software systems investment. The ROKG hopes to modernize a distribution sector dominated by mom-and-pop style retailing establishments before it is opened to foreigners in 1996. Government role in the economy ROKG macroeconomic policy was lauded in a 1994 OECD review of the Korean economy. Government spending and taxes as a share of GNP, as well as the fiscal deficit, are low by international standards. Moreover, the quality of public expenditure is high, with an emphasis on education and public works rather than transfer payments. The national savings rate has climbed dramatically since the ROKG made inflation control a priority in the early 1980s, and now roughly equals the gross investment ratio at about one third of GNP. At the microeconomic level, however, government intervention is extensive and costly in terms of economic efficiency. The prices of many products are de facto controlled. The ROKG allocates credit according to firm size and must approve all bond and stock issuances. Most overseas capital transactions are tightly controlled. Investment and product safety regulations inhibit domestic competition and discriminate against foreigners. ROKG task forces have been commissioned to rid the economy of obstructive and redundant regulations, but thus far progress has been marginal. The ROKG itself plays a direct role in the economy because a total of 133 public enterprises account for about 10 percent of GNP. The government admits that efficiency in the state sector is low, and a 1994 privatization plan calls for selling off 58 of these firms by 1998, and closing another 10. But the program is off to a slow start, and will be off grounds to foreigners who are prohibited from acquiring controlling shares in Korean enterprises. Balance of payments situation ROKG officials have noted, so far without alarm, that Korea's current account balance, which registered a $385 million surplus in 1993, is shifting back into the red. During January-April 1994 the current account deficit reached $2.8 billion, compared to a $820 million shortfall in the same period of 1993, and a late-May ROKG-private industry trade conference predicted a $2 billion deficit for 1994 as a whole. But the government argues that the deficit is chiefly due to rapidly growing capital goods and technology imports, which will improve competitiveness over the long term. The long term capital account registered net inflows of $8.8 billion in 1993 and $2 billion in January-April 1994, while the overall balance-of-payments surplus was $6.5 billion and $334 million for the corresponding time periods. Since the stock market was liberalized in 1992, Korea has received about $8.6 billion in cumulative foreign equity investment. However, with foreigners having largely exhausted their statutory 10 percent ceiling on equity investment, net flows into stocks turned slightly negative in March and April. As of the end of March 1994, Korea's gross and net foreign debts amounted to $45.1 and $8.7 billion respectively. Because net foreign debt equals less than 3 percent of GNP, debt management is no longer a significant issue for the ROKG. Foreign exchange reserves totalled $21 billion at the end of April 1994. Trade and investment barriers As tariff rates and quantitative restrictions on imports have fallen in Korea, nontariff barriers have become the chief concern of U.S. trade policy. Importers commonly have difficulty with customs and quarantine clearance procedures, particularly for products deemed to be luxury goods. Sanitary regulations have been employed to impede the flow of perishable imports - the Korean government's blocking of wheat and sausage imports underline problems in this area. A major impediment to trade is the limitation of deferred payment terms to imports with tariff rates of 10 percent or less, which are generally raw materials and capital goods. Korea's average tariff rate of 7.9 in January 1994 is still high compared to those of OECD nations. Moreover, tariff peaks are significant in some sectors, like agriculture, and Seoul also uses so-called adjustment and emergency tariffs to cushion liberalized sectors like textiles. Korea has a poor reputation for attracting foreign direct investment - FDI flows as a share of GNP rank only ninth among Asian economies, behind poorer nations such as Malaysia, Indonesia, and the Philippines. Chronic complaints by U.S. firms operating in Korea involve restrictions on their ability to finance overseas and to purchase land; arbitrary treatment by Korean tax authorities; and violations of patent, trademark, and copyright rights, although in this latter area the Koreans are improving their legal regime and beefing up enforcement. Foreign investment through merger or acquisition is prohibited. The ROKG announced in mid-June 1994 a new program to attract FDI, which offers a one-stop approval service for prospective investors, expanded land availability for factory sites, financing incentives for high technology firms, and tax holidays. This program has many promising elements, but the accelerated sectoral liberalizations promised under the program are hedged by joint venture or other stipulations. Also, under the new program foreigners will still be blocked from buying control of existing enterprises. Labor force Korea's well educated, 20 million-strong labor force is the nation's chief developmental asset. Labor productivity in the manufacturing sector has grown at over 10 percent per annum during the 1990s. Unemployment has traditionally been low, and dipped to a 2.6 percent rate in April 1994. The market is tight for skilled labor, and many firms complain about applicant shortages for technical positions. Wage demands, which intensified after unions were legitimized in the late 1980s, show signs of moderation. Manufacturing wages rose an average 10.9 percent in 1993, compared to 15.7 and 16.9 percent hikes in the previous two years. The ROKG is urging that large employers and unions forego outsized pay increases in 1994 in order to devote more resources to worker retraining. The government's pay guidelines were generally honored in the first half of 1994, but late summer contract negotiations at several large conglomerates could still prove troublesome. Labor relations have been a source of conflict at some foreign companies, especially banks. In 1993, two U.S. banks had disputes with their unions over wage and benefits that led to prolonged strikes. Major local and third country competitors in specific sectors The dominant position of conglomerates in the Korean economy represents a problem for foreign competitors. Chaebol companies will purchase from "family" suppliers whenever possible. Also, the ROKG encourages the "localization" of production and technology transfer when awarding public procurement contracts. Therefore, successful marketing in Korea generally requires products, services, or technologies that are unavailable domestically. Competition based chiefly on price terms is likely to prove disappointing. Despite Korea's position as an exporting center, the domestic capital goods industry is not world-class, resulting in a strong demand for U.S. manufacturing and electrical equipment, process controls, and customized machine tools. Japan is our main competitor as a capital goods supplier, and regularly outsells the United States, despite a ROKG "diversification" program directed against Japanese imports. U.S. aircraft and parts face no serious domestic competition, but Airbus has about a quarter of the civil aircraft market. Large-scale power generation, both nuclear and thermal, is a U.S. success story in Korea, despite strong Canadian and European competition. High tariffs, taxes linked to engine size, and past threats of tax audits have relegated U.S. and third country producers to a minuscule share of the booming domestic auto market. The rapidly growing pharmaceutical market is dominated by domestic firms, and industry association and ROKG rules make foreign entry via direct sales or investment difficult. The domestic chemical industry has greatly expanded its capacity in recent years, pushing foreigners into niche, specialty markets. Korea Telecom has a history of favoring domestic suppliers, but, due to a recent bilateral telecommunications pact, the United States has made inroads into the central switching market. Infrastructure situation regarding goods/services distribution While Korea advanced as a manufacturing center over the last two decades, its domestic infrastructure system remained relatively underdeveloped. Korean industry now regards transportation and distribution bottlenecks as a major impediment to competitiveness. Ports, railroads, airports, and highways are stretched to capacity. According to the Korea Chamber of Commerce, the shares of total sales consumed by logistical and distribution expenses was 18 percent in Korea in 1991, compared to corresponding ratios of 14.5 percent in Japan, and 12.4 percent in the United States. The retailing and wholesaling network is inefficient and high cost due to regulations designed to protect small shop owners. Modern retailing formats, such as discount stores, price clubs, or European-style hypermarkets, are either unknown or new to Korea. Until January 1996 foreign-owned chain stores will be prohibited, and foreign retailers will be limited to a maximum of 20 outlets, with floor spaces under 3,000 square meters. An early liberalization in 1995 may be offered for foreign car dealerships. Major infrastructure projects underway The ROKG is undertaking a massive program to upgrade the nation's infrastructure, which could involve about $100 billion in investment between 1993 and 1997. The government has proposed a bill to the National Assembly that offers incentives for private investment in infrastructure development. A sample of the estimated price tags on the major infrastructure projects underway in Korea include: $15 billion for the Seoul- Pusan high-speed rail project; $4.7 billion for the first phase of the new international airport near Inchon; $3 billion per annum through the year 2,000 to build nuclear and thermal power plants; $1.2 billion to construct LNG terminals and pipelines; $12 billion for subway construction in five cities; $20 billion for new express highway construction; and $10-$20 billion for seaport expansion.